Monthly Archive: July 2014

IRS Cost Basis For Beginners

Submitted by Chris Moss CPA

All business owners and entrepreneurs are at one time or another having to deal with a “basis” computation analysis when they sell their interests in the company they started. Likewise real estate developers and builders use basis to compute their gains and losses when they sell their property. Moreover, all taxpayers who sell real estate have to know their basis to compute a gain. Even if you sell your primary home you have to know your basis if the gain is over the $250,000 exemption ($500,000 married joint). But in the unlikely event of an IRS audit are you prepared to prove to the government your “basis computation” both inside and out? How can you bulletproof your annual tax return each year when it may not be for another ten or twelve years that you sell the property or membership interest? Is basis just your cost or does a valid indebtedness like a promissory note or mortgage increase your basis? Is you current tax advisor keeping annual track of your inside and outside basis and are you being informed of what your basis is each year?

To answer these questions, let’s head on down to the US Tax Court on Capitol Hill in Washington DC and take a look at some “basis” cases. First a few basics: Your individual “outside” basis is your cost to you of the real estate or membership or shares you purchased. The “inside” basis on that purchase is how the LLC or partnership values the real estate, membership or shares on their books on the balance sheet. As per the IRS partnership audit guide, “A partner’s basis in his/her partnership interest is referred to as “outside basis.” Upon formation of the partnership, a partner’s initial outside basis will generally equal the amount of money and the adjusted basis of property contributed. If the partner purchases his/her partnership interest, the outside basis will equal the purchase price.” The inside basis is how the partnership carries that partnership interest on the balance sheet of the books and records.

In Barnes vs IRS decided in March of 2012, Washington, D.C. based entrepreneurs Barnes were engaged in several different lines of business, including restaurants, nightclubs, and event promotion. The IRS audited the 2003 tax return for Barnes almost 5 years later and by June 3, 2008, the IRS issued the Barnes a statutory notice of deficiency, determining a deficiency in tax of $54,486, a section 6662(a) accuracy-related penalty of $10,897, and a section 6651(a)(1) late-filing addition to tax of $5,691 with respect to their 2003 return. Judge Morrison’s 44 page Opinion meticulously, methodically, and almost painstakingly precisely, goes through year by year from 1995 to 2003 to conclude that the Barnes tax advisors had computed his cost basis incorrectly over the years thereby ultimately giving the Government victory in Court.

Note the government does not fool around during a basis computation audit either in a small simple case like Barnes or a bigger more complex 2005 case like Santa Monica Pictures and Corona Film vs IRS. This 332 page opinion by Judge Thornton involves complicated transactions that occurred in the wake of the 1996 sale of the “legendary motion picture company Metro-Goldwyn-Mayer (MGM) by the French banking giant Credit Lyonnais.” Peter Ackerman, his business partner Perry Lerner, and their related entities (Ackerman) had helped organize a consortium which made a bid to purchase MGM from Credit Lyonnais. Although Ackerman lost out to Kirk Kerkorian’s winning bid, Ackerman nevertheless set out to acquire MGM’s parent company, Santa Monica Holdings Corp. (SMHC) which Credit Lyonnais still owned. Ackerman set up a controlled partnership Santa Monica Pictures (SMP) which successfully bid to purchase SMHC. A short time later SMP then sold the assets of SMHC at a loss to various other entities allowing SMP to deduct over $400 million in losses. The IRS audited the basis computations and disallowed all losses claiming the losses were based on invalid basis computations by Ackerman because the whole series of transactions lacked a primary business purpose. Judge Thornton in finding for the Government sends a strong message that “cost basis” computations are valid only for parties doing legitimate business together with tax savings playing a secondary role. “The transaction between the banks and Ackerman carried the seeds of its own undoing: it depended upon the banks’ withdrawing from the very partnership they purported to join. The banks’ “contributions” to the partnership were not intended to have any economic significance apart from transferring built-in tax losses.” Id at 226.

Finally, in Moore vs IRS Moore reported on his 2005 Schedule D, Capital Gains and Losses, a capital loss of $1,502,519 from Mr. Moore’s sale of the ATS stock. In calculating the capital loss, his CPA Catherine Fox from BDP Seidman reported a basis of $4,502,519 in the ATS shares. The IRS audited Moore’s basis computation for 2005 and recomputed the 2005 tax return to show a $1 Million basis. Moore appealed to US Tax Court. The facts in the case are relatively simple: In turns out ATS loaned Moore $5 Million to buy ATS stock from Baker in 2000. In 2002 however Moore sued ATS claiming he was misled to the value of ATS. Moore eventually won a judgment allowing Moore to reduce his debt to ATS to $1 Million the actual market value of the stock that Moore purchased. As a result on December 31, 2002 ATS decreased Moore’s loan by over $5 Million and then increased on the same date the loan to $1 Million. In 2005 Moore sold all his ATS shares for $3 Million. Judge Thornton easily concludes that Moore’s original debt to ATS was not absolute and that the actual debt was only $1 Million. Therefore the Court concluded Moore had a gain of $2 Million- sales price of $3 Million less cost basis of $1 Million.

What does all this mean for us? In my view the IRS aggressively is auditing taxpayer basis computations, usually finding that the taxpayer basis was incorrectly computed, and is winning regularly in US Tax Court. What can you do to help protect your tax return from adverse audit consequences? Next time you meet your tax advisors make sure they discuss with you how they are keeping track of your basis each year to year and whether or not they are prepared to defend your basis in the event of an IRS basis adjustment audit. Each taxpayer has unique basis issues and so there is no “cookie cutter” basis computation for all taxpayers. Best practice requires your tax advisor to go over with you in person all your real estate purchases and sales including purchases, sales, acquisitions and mergers of closely held partnership, LLCs and corporations. Finally when you sell anything that has a basis have your tax professionals fully disclose your basis calculations in your tax return prior to filing that tax return. You can then relax knowing your tax returns are bulletproofed, safe and secure against IRS audit. How cool is that?

Thank you for us on TaxView with Chris Moss CPA

See you next time, Kindest regards
Chris Moss CPA

IRS Audit Statute of Limitations

Submitted by Chris Moss CPA

The US Income Tax Return form 1040 is probably one of the few annual forms that just about all Americans sign, either manually or electronically, under penalty of perjury. The exact phrase you certify in a quasi-oath like setting is: “Under penalties of perjury, I declare that I have examined this return and accompanying schedules and statements, and to the best of my knowledge and belief, are true, correct, and complete.” I don’t know about you all, but how many of us really understand everything on our tax return as we give the tax preparer the go ahead to file our returns each year.

So I would not be surprised if most of you did not welcome the thought of an IRS audit commencing up to three years from the date you filed your tax return as per IRS Code 6501. But did you know there are three “statute extenders” that the IRS has at its disposal to audit us even after 3 years? One is the 25% or more understatement of income. The second is unreported foreign financial asset income of more than $5000 and the third extender is fraud or criminal attempt to evade tax. The 25% extender is straightforward: You report $100,000 of taxable income from earnings but omit another $30,000 of dividends and interest. Equally clear-cut is the $5000 extender; you report $100,000 of taxable income from earnings but omit $5000 of foreign dividends from that secret Swiss bank account. In each of these extenders your statute of limitations is 6 years. The Fraud or Criminal evasion extender, or what I call the “Ultimate Forever Extender, (UFE) has no statute of limitations, imposes very large penalties, and for about 2000 taxpayers a year, carries criminal prosecution and prison. Will any of these powerful extenders come into play with your tax returns? Will an audit of your tax return head south to fraud and criminal investigation? You say no way! I say perhaps someday if you don’t know the way. Keep reading to find out how to stay free of UFE.

Let’s take a look at what’s happening in US Tax Court. We start off with a Judge Halpern opinion Scott v IRS, US Tax Court decided in March of 2012. Scott was a dentist whose 1994 tax return was selected for audit by the IRS in 1996. For reasons that defy logic Scott did not cooperate with the examining agent Thomas Demeo. By 1997 Agent Demeo expanded the audit to 1995. Without the cooperation of Scott, Demeo was forced to go directly to the bank with official summons to review the original bank records. With the audit still going strong in 1998 the statute of limitations of 3 years was fast approaching. Most likely due to Scott’s lack of cooperation, the case was referred to Criminal Investigation Division (CID). But CID apparently did not find a criminal case so CID sent Scott back to civil examination sometime after 1999. By 2000 Scott had outlasted Demeo and a new agent was assigned to the case Agent Barbati. Eventually Barbati assessed a tax for 1994 95 and 96 many years after the statute had run and the notice of deficiency and 90 day letter was issued to Scott alleging he owed almost $300,000 in tax and $200,000 in penalties. Scott appealed to US Tax Court arguing the three year statute of limitations had run. The government claimed a UFE, the “Ultimate Forever Extender” and set about to prove that Scott was guilty of tax fraud thus unleashing the dreaded UFE.

The key question presented then for Judge Halpern was whether there was intentional wrongdoing of fraud with the specific purpose of avoiding a tax that Scott knew was owed to the government. If this question was answered affirmatively the IRS would be empowered to activate their UFE allowing the government an easy win. If not, the case would be dismissed due the 3 year statute of limiations having run out allowing the Scott to win. After a careful review of all the facts, Judge Halpern finds for the government, relying on his own 2011 Opinion Browning v IRS . Citing Browning, Judge Halpern applies the 11 factors or “badges of fraud” to the Scott case. The eleven badges of fraud are: 1, Understatement of income, 2, inadequate records, 3. Failing to file tax returns, 4. Implausible explanations of behavior, 5. Concealment of income 6. Failing to cooperate 7 engaging in illegal activity, 8 intent to mislead 9. Lack of credibility of testimony 10 filing false documents and 11 the last one, dealing in cash.

While the Court found many of the 11 badges of fraud in Browning applicable to Scott, in my view, the facts in Browning are very different than the facts in Scott. Browning owned a Vermont based manufacturing corporation. On advice of his tax advisor Browning allegedly illegally moved funds offshore. From these offshore accounts Browning used credit cards to purchase goods and services for personal use with funds that had not been taxed. In addition Browning allegedly tried to mislead the IRS during the audit about this scheme. As I see it Browning’s deception to the government was worse than the offshore scheme itself. With an easy win for the government the IRS received the power of the UFE years after Browning’s three year statute had run its course.

However unlike Browning, Scott did not mislead or deceive the IRS as Browning did during the audit. It was Scott’s failure to cooperate with authorities, his lack of organized books and records, and his lack of credible testimony that eventually did him in. The IRS thus became empowered with the UFE against Scott leading the IRS to victory in US Tax Court. Scott eventually paid all his tax he owed plus a 75% fraud penalty and surely massive amounts of interest. Just so you know, if Scott had cooperated with the IRS examination division in the first place, my guess is that he could have avoided the 75% fraud penalty and perhaps just got hit with a much lower substantial understatement penalty instead. However, on a positive note, Scott was fortunate (as was Browning) to avoid a criminal prosecution and possible jail time.

What does this mean for all of us? The IRS has three years to review your unique situation and decide whether or not to audit your tax return. Make sure you don’t empower the IRS with UFE. Fully disclose each year what is going to your tax professionals. Have your tax professionals insert into your tax returns anything unique in the tax strategy you are using each year. For example, if there is some question as to how much you received from a customer, or whether the amounts received were fully taxable, disclose in a footnote in the tax return before you file why you didn’t report all this income. Moreover, if you own a business as did Browning or Scott or have a somewhat complex financial situation you would be well advised to retain the appropriate tax counsel who could both prepare and file your returns and also be there for you years later to represent you in the event of an IRS audit, all a long maintaining that very important attorney-client privilege with you. If you are audited three, four or five years later, pull those books and records with confidence down from the Cloud to make sure your records are 100% complete. In conclusion, good records, open and honest disclosure in the actual tax return prior to filing, and cooperation with the IRS examination division will go a long way in avoiding the Ultimate Forever Extender. May you live long, prosper and avoid the UFE.

Thank you for joining Chris Moss CPA on TaxView.

See you next time,
Kindest regards
Chris Moss CPA

Who Owns Your Accounting Records?

Submitted by Chris Moss CPA

In reading a recent 143 page 2012 US Tax Court Opinion F.Lee Bailey vs IRS I ask why a famous attorney would not have his accounting records in the Cloud. In the Bailey case Judge Gustafson says “there is no provision that excuses taxpayers from retaining their records…taxpayers are required to retain their books and records as long as they become material….” Similarly Judge Gustafson presiding over a 2013 US Tax Court Opinion Graffia v IRS notes “For many of the disputed points in these cases, Graffia lacks records entirely”. While records created by Bailey and Graffia were lost, destroyed, or misplaced, there was no question that Bailey and Graffia owned those records. But when your accounting records are in the Cloud, all 20th century rules of ownership become airborne. You might think you own your records after you scan raw data into the Cloud to your bookkeeper for processing. But it is not so clear as to who owns the processed financial data or “accounting records” that are created from all those scanned documents.

In order to see how critical it is that you have control and ownership of your own accounting records in the Cloud think about these possible very realistic scenarios occurring to you and your business: Have you all thought of what might happen if the IRS subpoenaed your ex-bookkeeper who did not leave your company on the best of terms, to testify before a Grand Jury? Or perhaps your ex-wife has sued you for increased alimony and she subpoenas your bookkeeper to a family court hearing? Or even more realistically disgruntled ex-employees have a court issue discovery requests for documents sent directly to the outside bookkeeper and to the company that maintains the bookkeeper’s server, and this bookkeeper no longer works for you? How would you handle that? What if your outside bookkeeping company goes out of business or changes ownership? You call to get your records only to find out that the provider who had your records on their server no longer does business with your former outside accountant who has left the state, or worse the country.

Let’s think “out of the box” by comparing processed accounting records on the Cloud to your Domain name on the Internet. Who owns your domain name? You own your domain name if you are the “Registrant” AND you are the “Administrator” on ‘WHOIS”. What or Who is WHOIS? “WHOIS” is the entire Internet domain data base. Before we get to WHOIS we need to rewind back to President Eisenhower who created the Advanced Research Projects Agency (ARPA) in 1958. ARPA eventually evolved into two agencies, the Advanced Research Projects Agency Network (ARPANET) and the Defense Advanced Research Projects Agency (DARPA), both US Government Dept. of Defense agencies. DARPA and ARPANET created a protocol called WHOIS to keep track of ownership of domain names. Eventually the Government granted a few private businesses including Network Solutions in 1993 the authority to assign Internet domains and the rest is history.

Fast-forward to 2014 and WHOIS. Google WHOIS until you get in the WHOIS data base. Type in your domain name and see who owns your domain name. Don’t be surprised or concerned if you see your IT person as the Technical or Billing contact. But you the business owner should be “Registrant” and the “Administrator”. If you are not, you are not legally the owner. There is one exception and that is private registration. Yes, you may have a “private” registration which allows you to keep your identity secret from the public. But the sad fact is that under a “private” registration you have almost no way to prove to a Court that you are the legal owner if your IT people decide to quit the company and take the domain name with them and worse case shut your web site down.

Perhaps you see where I am going now. As goes domain ownership, so goes bookkeeping records ownership. When you scan your accounting records to the Cloud the work product like the check register produced from all those original documents will be owned by the “Administrator” who is on your cloud provider’s data base. Your Cloud Provider is giving your company server space somewhere in the world. Most likely the Cloud Provider was retained by your outsourced Bookkeeper and more than likely I would guess your Bookkeeper is the “Administrator”. You may also or may not be the “password Administrator”. However, the password “Administrator” for the password may or may not be the legal “Administrator” with the Cloud Provider. As with the Domain IT person, the renegade Bookkeeper could shut your accounting Department down in seconds and you may have little recourse if you are not the Administrator.

Are you confused? Sorry there is no easy answer here but there are some steps you can take right now to better protect and keep safe your cloud accounting records. Consult your attorney and make sure your legal department confirms that you are the administrator of the account with your outside bookkeeper or accounting service. Further work with your legal department to make certain the outside Bookkeeping Service has a lower security password than you so if in an emergency you could prevent the Bookkeeper from having access to the system. Make sure the Cloud provider the bookkeeper contracted with has a separate space on their server in your name and reserved for you. If you are not using the outside bookkeeper’s server, but using a QuickBooks Cloud type provider you may not have a separate legal ownership on the space they provide for you on their server. If all else fails, I recommend you call your legal counsel or legal department to create a bullet proof contract between you and your outsider bookkeeping service to better protect you. Finally, make sure to ask your attorney, “Who Owns Your Accounting Records”, and get the answer in writing. Good luck and thanks for joining me here on TAXVIEW with Chris Moss CPA.

Kindest regards and see you next time,
Chris Moss CPA

IRS Fights Conservation Easements

Submitted by Chris Moss CPA

Are you planning to gift a conservation easement on your land or home in accordance with Section 170 of the IRS Code? Or have you gifted a conservation easement a few years ago and are benefiting from the carryforward year after year? Listen up conservation easement advocates: IRS may be watching you: The government could be planning on auditing your charitable deductions and unleashing a value diminution trap (VDT). What you ask is a VDT and how can a VDT be used against you in US Tax Court. Please continuing reading to learn how to protect your charitable deduction carryforwards as we observe the VDT in action in a recent US Tax Court case decided in May of 2014: Chandler v IRS 142 T.C. No. 16. Avoid the mistakes the Chandlers made when they deducted their conservation easement and learn how to bullet proof your tax return so that your deductions and carryforwards are safe and protected in the event of an IRS audit and ultimate appeal to US Tax Court.

The Chandlers had gifted façade easements on two of their homes. The Chandlers then retained professional appraisers. According to the appraisers, the properties lost $562,650 of their combined value because of all the restrictions placed on the homes by the facade easements. The Chandler’s CPA then deducted a large charitable donation in 2004 which carried forward to subsequent years 2005 and 2006 and beyond. The IRS audited the Chandlers for tax years 2004 2005 and 2006. The IRS disallowed all the charitable deduction and carryforwards claiming that the easement deduction was overstated and the appraisals were worthless. How did this happen?

Let’s look specifically at the facts: Both Chandler homes were in Boston’s South End, which the Federal Government has included in the National Register of Historic Places and designated a National Historic Landmark District. Chandler’s donated a “façade easement” to the National Architectural Trust (NAT) which severely restricted what the Chandler’s could do to the property without the permission of NAT. The Chandler’s were told by their professional appraisers the easement under NAT would reduce the value of their homes by $562,650. Unfortunately for the Chandlers this tax strategy had them walk directly into an IRS trap, the VDT trap. After the trap was sprung on the Chandlers during the government audit, the IRS argued that the easements under local government, South End Landmark District Commission (SELDC), were equally restrictive as those of NAT, thereby making the easements under NAT worthless. The Chandlers appealed to US Tax Court.

US Tax Court Judge Goeke gave much weight to the value diminution traps that had been spread all over the country by the IRS. Judge Goeke also relied heavily on Kaufman T.C. Memo. 2014-52, finally decided in March of 2014, just a few months before Chandler. Judge Halpern handed a major victory to the IRS and this victory appears final. I say appears final because Kaufman lost (Kaufman 1), had resubmitted the case for reconsideration (Kaufman 2) and then after Kaufman lost again, appealed to the 1st Circuit (Appeal). The 1st Circuit reversed Judge Halpern and remanded the case back to Tax Court (Kaufman 3). Kaufman v. Commissioner (Kaufman 1) Kaufman 2 and Kaufman 3, on remand from the U.S. Court of Appeals for the First Circuit, Kaufman v. Shulman, 687 F.3d 21 (1st Cir. 2012). Let’s take a closer look at Kaufman 3. where as I mentioned appears final now

On review of Kaufman 3 Judge Halpern relies heavily on the IRS star expert witness appraiser John C. Bowman III. Mr. Bowman has been certified by the Commonwealth of Massachusetts as a State-certified general real estate appraiser. He has received a Certificate of Completion for the Valuation of Conservation Easements program offered by the American Society of Appraisers (and other organizations) and is endorsed by the Land Trust Alliance. His appraisal work includes a particular emphasis on conservation and preservation restrictions. He has served on the Boston Landmarks Commission for 10 years, serving as chairman of the commission for 6 years. He has extensive experience appraising partial interests in real property, including conservation easements.

Mr. Bowman believed that no value was lost after Kaufman received a facade easement on his property thus no charitable contribution deduction was available. Kaufman’s experts and original appraiser, Hanlon did not seem credible to Judge Halpern who had little confidence in Hanlon’s opinions. The Court concluded both “Kaufman and Hanlon failed to persuade us on account of the preservation agreement, lack of control and lack of marketability that the easement reduced the value of the property. To the contrary, Mr. Bowman’s expert testimony has convinced us that the restrictive components of the preservation agreement are basically duplicative of, and not materially different from, the South End Standards.”

By the way, just so you know, guess who the IRS used as their expert witness in Chandler? You guessed it, Bowman. I am not sure if Bowman is still testifying for the IRS, but just in case he is, you probably want to retain the services of a really good and probably very expensive army of qualified appraisers who are equally as good as Bowman before you file a tax return with a conservation easement charitable deduction.

How critical is the expertise of your appraiser? I found a very informative piece underscoring the importance of performing a good appraisal to bullet proof your tax return in a Journal of Accountancy article written in 2011 by C Andrew Lafond CPA and Jeffrey J Schrader CPA. The article emphasizes the importance of obtaining at least two appraisals with the following caveat: “Given the significance of the appraisal as to the value of the donation and the ability of the donation to withstand an IRS audit, donors should engage an appraiser who has experience in valuation of conservation easements and whose appraisals have successfully withstood IRS examination during audit and appeal to US Tax Court. If the dollar value of the donation is significant, it may be wise to obtain two appraisals.”

In conclusion, as I see it, your charitable tax deduction is simply in many cases based solely on an educated guess by appraisers some of whom are better than others. What this means for any of you contemplating gifting a conservation easement is that much of whether you win or lose in US Tax Court is going to depend primarily on how good your expert witness appraiser does on the witness stand and how much time the appraisers used to assess and back up their numbers and conclusions. Indeed, in my view, if you want to bullet proof your tax return from IRS attack and subsequent US Tax Court appeal, you had better get the best two appraisers out there to avoid an IRS VDT. On second thought, get three if you think Bowman has set a VDT in your neighborhood..

Thanks for joining Chris Moss CPA on TaxView.

Kindest regards from Chris Moss CPA

Completed Contract Method: Howard Hughes Tax Court Case

Submitted by Chris Moss CPA

If you read my last article on the Completed Contract Method of Income Tax Deferral we concluded that Shea v IRS was a big win for the developers. Unfortunately the IRS has come back with a vengeance in June of 2014 with a big win in Howard Hughes v IRS. (Hughes) Why did the government win big against Hughes and lose against Shea? What can you all do differently to avoid this adverse Hughes ruling in the event of an IRS audit against your development company? How can you align yourself with Shea so that you win if your case after IRS audit should proceed to US Tax Court? To answer these questions I suggest anyone out there who is a real estate developer currently developing residential communities to keep reading if you want to protect your income tax deferrals against adverse IRS audit consequences on your 2014 income tax return.

Let’s take a look at the facts in the Hughes case: Hughes was a large land developer of Summerlin, approximately 22,500 acres on the western rim of the Las Vegas Valley about nine miles west of downtown Las Vegas. Hughes created and paid for the massive master planned community as approved by Las Vegas and Clark County, and signed 30-year agreements enabling Hughes to develop the land without the necessity of separate village by village agreements. Hughes profits and sole source of revenue from Summerlin derived primarily from 4 categories, pad sales, finished lot sales, custom lot sales and bulk sales. These sales were made to builders and consumers with the intent the builders and customers would build homes on the land that Hughes sold. Hughes deferred tax on much of their residential related revenue based on the completed contract method asserting that Hughes was in the home construction business. In accordance with IRS regulations, taxable income was recognized when 95% of the estimated costs allocable to each lot were incurred.

The IRS audited Hughes for 2007 and 2008 and disallowed Hughes from using the completed contract to defer what would have been taxable income in various villages throughout Summerlin. As a result the IRS adjusted Hughes income upwards hundreds of millions of dollars resulting in a tax deficiency of over $120 Million. Hughes appealed to US Tax Court. The question presented to US Tax Court Judge Wherry: Whether the long term construction contracts being used by Hughes were “home construction contracts” as defined by 460(e)(1)(A)(B). If Hughes could prove to the Court that their contracts were “home construction contracts” then Hughes wins, if they can not, then the Government wins. Seems to me a pretty black or white case or perhaps not?

The “gray” in this case starts with the basic provision of the IRS Tax Code that allows for this very lucrative tax deferral by defining “home construction.” “Home construction” is defined as 80% or more of the contracts costs are for the construction of dwelling units and improvements to real property directly related to such dwelling units. The IRS argued that Hughes did not build homes on the land they sold and therefore their expenses were not for “home construction”. Hughes argued that the IRS statute “contemplates a broader definition of home construction costs.” Hughes further argued that as long as a cost in some way benefits the dwelling unit those costs should count towards meeting the 80% test. Under this view all their development costs were attributable to dwelling units and real property improvements.

Unfortunately for Hughes, Judge Wherry gave little weight to Hughes argument because Hughes did not offer even one case to support its tax position. Judge Wherry instead attempted to look to the legislative history as to how Congress felt about “home construction”. The Court noted that “While the conference report is ultimately silent as to why the exception was added in its final form, it is clear that the intended beneficiaries of this relief measure were taxpayers involved in the building construction reconstruction or rehabilitation of a home and not land developers who do not build homes, even if essential development work paves the way for and thus facilitates home construction.”

Continuing in his analysis, Judge Wherry distinguishes Hughes from Shea by noting that “…at no point in Shea did we say a home construction contact could consist solely of common improvement costs. The starting point in Shea was that the taxpayer’s contracts were for construction of qualifying dwelling units…Shea developed land and built homes…so we permitted Shea to add the cost of the dwelling units they constructed to their common improvement costs.” Judge Wherry concludes that “our Opinion today draws a bright line. Developers can qualify their home construction contracts for income tax deferral only if the developer builds integral components to dwelling units or real property improvements directly related to the site of each unit. If we allow developers the completed contract method to defer tax who have construction costs that merely benefit a home that may or may not be built then there is no telling how long deferral would last.”

In conclusion, the Court in Hughes has made it very clear to all developers who are counting on a tax deferral based on a completed contact method to make certain that their contracts include residential home building. And yes as I am sure you noticed by now, perhaps by an ironic coincidence, but certainly making the cases interesting, US Tax Court Judge Wherry presided over both Shea and Hughes Finally after the government victory against Hughes I believe that the IRS will be aggressively moving against the completed contract method being used by small and large developers alike. So if you are a developer in residential construction I would advise especially after Hughes for you all to carefully review your contracts with your contract attorney and tax attorney prior to filing your 2014 income tax return to make certain that Shea facts are controlling rather than Hughes in the event of an IRS audit. Thank you for joining us and look forward to seeing you all next time on TaxView with Chris Moss CPA.

Kindest regards
Chris Moss CPA

Completed Contract Method Income Tax Deferral

Submitted by Chris Moss CPA

Many real estate developers use the Completed Contract Method (CCM) of income recognition as they develop large tracts of land into buildable lots and ultimately residential housing around the nation. This special method of revenue recognition is allowed for small developers earning less than $10 million who anticipate a 2 year date of completion on their project. Also qualifying are general residential construction developers regardless of size or cost as long as their project qualifies under IRC section 460(e)(1)(A) as “home construction”. If you use this method of income tax deferral be aware that the IRS has in recent years become very suspect of the use of CCM. A 2009 IRS Memorandum asserts that the abuse of CCM is a growing trend within the residential construction industry. The IRS further asserts that “Taxpayers are improperly treating residential land sales contracts and long-term construction contracts (including contracts for subcontract work for common improvements) as home construction contracts eligible for CCM. The IRS further says that taxpayers are postponing recognition that a contract is considered complete to improperly defer income (and expenses) under CCM. However a 2014 US Tax Court case appears to grant wider latitude to real estate developers on how long taxes can be deferred. This is great news for the hardworking real estate developer community. So listen up all real estate developers in America: We are headed to US Tax Court to learn about a case that may change your life: Shea Homes v IRS 142 Tax Court 3 (2014)

The Shea family developed real estate through various family entities (Shea) for more than 40 years. Their business involved the analysis and acquisition of land for development and the construction and marketing of homes and the design and/or construction of developments and homes on the land they acquired. Shea entered into standard sales contracts with prospective homebuyers requiring earnest money deposits. Contracts could not close until all improvements were made or bond was posted. Shea used CCM for all its qualifying developments. Shea was audited by the IRS for year 2004 2005 and 2006 and ultimately appealed to US Tax Court on the key issue of when income tax deferral should have ended. The Government said the contracts were completed sooner than Shea reported and claimed that Shea should recognize income when the actual contracts closed and the buyer moved into the house. Shea argued that closing the contracts did not complete them as per the clear language of the contracts even if the buyer moved into the house. Shea further argued specifically that the contract language encompassed the entire development and therefore was not yet complete at closing. Shea concluded that final completion and acceptance triggering the end of the tax deferral did not occur until the final road was paved and the final bond was released. After an in depth analysis of the various contracts Judge Wherry brilliantly observes the “buyers of their homes understood and believed that the parties had contracted for the entire lifestyle of the development and its amenities, more than just the purchase of the home itself.”

Judge Wherry continued: “Thus, at the very minimum, the 95% completion test, as applied here, looks to costs beyond just those associated with the house, the lot, and improvements to the lot….The final completion and acceptance test also indicates that the subject matter of the contract in these cases is more than just the house, the lot, and improvements to the lot. Ultimately, this outcome is supported by our conclusion that Shea’s contracts consist of more than the purchase and sale agreement alone. When the contract documents are read together, the subject matter of the contract is quite clearly more than just the house, the lot, and improvements to the lot.” Id at 71.

This is great news for real estate developers but I advise caution: Judge Wherry in his final footnote on page 82 warns: We are cognizant that our Opinion today could lead taxpayers to believe that large developments may qualify for extremely long, almost unlimited deferral periods. We would caution those taxpayers that a determination of the subject matter of the contract is based on all the facts and circumstances. Further, sec. 1.460-1(c)(3)(iv)(A), Income Tax Regs., may prohibit taxpayers from inserting language in their contracts that would unreasonably delay completion until such a super development is completed.

In conclusion, if you are a real estate developer who qualifies to use the completed contract method for income tax deferral, I advise you to work carefully with your contract attorney and your tax attorney in the same room at the same time to make absolutely certain prior to filing your 2014 tax return that your contracts have the appropriate language to defer income tax under Shea case law. Once the contracts are finalized, I would recommend you consult with your tax advisor and CPA to include at minimum in the tax return prior to filing that return the necessary contract summery explanation specifically focusing on Shea requirements to bullet proof the tax return against IRS attack in anticipation of a government audit. A bullet proof tax return with the necessary contract documentation is absolutely critical if you expect to win in US Tax Court as Shea did. Thank you all for visiting Taxview with Chris Moss CPA.

See you next time. Kindest regards from Chris Moss CPA

Healthy Living Tax Deductions: Gym Memberships

Submitted by Chris Moss CPA

Most taxpayers deduct medical expenses on their tax returns either as individuals or through businesses. Deductions like health insurance premiums or doctors and dentists fees are pretty black and white if you are being treated for illness. But what about that gray area of preventative medicine including supplements, gym memberships and fitness equipment and similar nontraditional alternative medical cures and treatments? Take for example the cost of joining a gym. You are not unhealthy or sick but your doctor tells you to join a gym. You know that the medical community says regular exercise promotes good health. In fact, more and more health insurance plans are covering the cost of a gym membership as evidence that working out builds the immune system to fight off cancer and other disease. Has the time come for the IRS to recognize that gym membership fees are medical expenses? I call these tax deductions “Healthy Livings Tax Deductions” (HLTD): Unfortunately the Courts have been reluctant to recognize HLTD as bonifide tax deductible medical expense. Let’s take a better look at why HLTD are so controversial, particularly with gym memberships. I invite you all to meet me in a few minutes for a brief tax deductible work out at your local Tax Court to see how the case law is trending about gym memberships these days. So let’s get started on our HLTD workout.

In order to see the IRS mindset on gym memberships we start off at a slow but steady pace with Humphrey vs Commissioner TC Memo 2013-198. In this 2013 case medical care is defined as amounts paid “for the diagnosis, cure, mitigation, treatment, or prevention of disease, or for the purpose of affecting any structure or function of the body.” Mr. Humphrey fought Pro Se against the government and actually won the right to deduct his supplements to help with his Prostate cancer. How did he win? Judge Goeke felt that Humphrey provided credible testimony regarding studies from Harvard Medical School, and the Mayo Clinic promoting the use of supplements to prevent cancer. Unfortunately Humphrey lost the right to deduct his gym membership. Why? Because the Court said to deduct gym membership as a medical expense, a taxpayer must show the expenses were in excess of or different from what he would normally spend for personal purposes. The Court cited: Fred W. Amend Co. v. Commissioner, 55 T.C. 320 (1970). Amend was a company that hired a spiritual advisor for the health of an executive. The IRS said spiritual advisor expense was not a medical deduction deductible by the company. Amend appealed to the 7th Circuit and lost.

I don’t know about you all, buy regardless of whether Amend won or lost, what does Amend have to do with a gym membership? Is the best the government can do to cite a 43 year old case? Judge Goeke stated that Humphrey failed to show the gym membership to Bally Total Fitness was in excess of or different from what Humphrey would normally spend. So perhaps if Humphrey had consulted with his Doctor about joining a top of the line $1000 per month health spa the membership would qualify as an HLTD? Actually better yet Humphrey should have had a Doctor and an Attorney at court with him. In my view he would have perhaps had at least a chance to win. But don’t let this diversion get you distracted from your work out.

Let’s pick up the pace with Battle v Commissioner T.C. Summary Opinion 2007-27, Mr. Battle says as a fireman his “my tool is my body” and therefore required a gym membership. Special trial judge Dean disagreed. A gym membership fee is an inherently personal expense. It is desirable to be physically fit regardless of one’s profession. Mr. Battle has not offered any evidence to show that his gym expenses were different from or were in excess of what he would spent for personal reasons. Id at 9-10. I’m sorry, but are you thinking what I’m thinking? This taxpayer says “my tool is my body” and he thinks he is going to win in US Tax Court with a $708 annual gym cost in 2002? You guessed it, Mr. Battle went up against the Government Pro Se. I think he would have been better off hiring a tax attorney.

Warning: Maximum performance ahead with Hamper v Commissioner Tax Court Summary Opinion 2011-17. Ms. Hamper was a television news anchor. She deducted a gym membership because her position as a news anchor made her a public figure in her local area. Hemper was one of the unfortunate public figures affected by stalking and was advised by the local police to undertake self-defense classes as a protective measure. Special Trial Judge Dean (yes the same judge from Battle) says that “….although petitioner testified that she enrolled in self defense classes with a private instructor, the only substantiation relating to self-defense classes for the years at issue was her gym membership dues at Lifetime Fitness. Furthermore, petitioner’s daily log for 2005, which provided a detailed account of her weekly schedule, does not indicate that she attended self-defense classes. On an almost-daily basis petitioner noted her workout for each day, which included kickboxing, yoga, running, walking, weights, and cardio. But any reference to self-defense classes was notably missing from the log….” (Id at 12). Judge Dean ruled in favor of the IRS and disallowed her gym membership. Unfortunately just like Battle, Hamper was not represented by a tax attorney.

Great workout. Let’s spend time to rest and reflect on a very taxing question: Do you spend a lot of money on health care for you and your family but have not deducted your gym membership on tax returns? You may have HLTD if you purchase a high end specialized gym membership for you all. Don’t forget to obtain a doctor’s letter approving and recommending your membership as as it applies to your specific health situation. If your tax advisor agrees, you might be able to deduct the difference between a regular low end membership and the high end specialized program you signed up for. Finally make sure you attach your doctor’s letter into your tax return prior to filing to bullet proof the return in the event of an audit.

See you next time at the gym on TaxView.
Submitted by Chris Moss CPA

Business Air Travel

Submitted by Chris Moss CPA

For small businesses with fractional jet ownership or for any business owner who leases aircraft for travel here are some important changes to your flight plan before we take off for a tax deductible and enjoyable summer business trip. Attention all business travelers: The IRS has control of the flight paths right now so proceed with caution on the runway before takeoff. The Government has been winning big in US Tax Court proving rather easily that the taxpayer’s travel is personal in nature and therefore not deductible. Landing in Tax Court without an approved flight plan ends your trip before you even take off. So power off your phones and listen up as you receive your new and revised flight instructions to bullet proof your tax return against a crash landing if audited by the government. Before we take off, please follow along with me as we go over the necessary safety instructions in the event of adverse IRS weather: Your survival in case of crash landing into US Tax Court will depend on the unique facts that you record to create a credible history of the business nature of your trip. So go ahead and record extemporaneously and contemporaneously the facts needed to prove the business nature of the trip, even if by video or audible recorded by your spouse and kids. Your tax deduction may depend on it.

As we gain altitude you can see on your left the US Tax Court in Washington DC. We observe through the cloud cover DIDONATO v Commissioner Docket No. 1_14_2013. Dr. Didonato and his wife headed south directly into an IRS audit. Their Tax Advisor thought nothing of it until the audit turned into a full fledged Tax Court twister of doom. Judge Laro of the US Tax Court did not find Dr. Didonato’s testimony credible and disallowed all Didonato’s plane trips. By the way, you can turn on your electronic devices now. As you can see, the cross examination by Judge Laro of Didonato from page 46 to 58 allows you a clear observation on this taxpayer’s credibility. If you want to avoid the 130 page grand view, go directly to page 85 as you hear Judge Laro in the distance: “As to trips 2, 4, 5, 7, and 10, Didonato testified at trial that each of these trips were for the sale of his personal shares of ASC stock. As explained in this opinion, expenses related to the sale of a shareholder’s stock in a corporation are not deductible by the corporation as a business expense of the corporation. See Snyder Bros. Co. v. Commissioner, 40 T.C.M.

Remember the safety instructions? If Didonato’s CPA or Tax Attorney had simply documented with the company that trips 2, 4, 5, 7 and 10 were not for the personal benefit of the shareholders but were to be trips to benefit the corporation for possible merger or acquisition I believe these trips would have been 100% deductible. These facts or “history” should have been documented in the actual tax return prior to filing that tax return. In other words Didonato could have deactivated auto pilot and manually made a critical turn to safety based on better record keeping before takeoff if his CPA documented these facts in the actual filed tax return. Without the facts or history of the trip inserted into the tax return Didonato was certain to crash land into enemy IRS territory.

But we are not out of this storm yet as we still have to land in what looks like a major tropical depression. Judge Laro thunders: “Even if we were to believe that one or more of the trips taken had a legitimate business purpose, we agree with respondent that no deductions are allowed because the heightened substantiation requirements of section 274(d) have not been met. See Lysford v. Commissioner, T.C. Memo. 2012-41, 103 T.C.M. (CCH) 1217, 1220-1221 (2012), See Weekend Warrior Trailers, Inc. v. Commissioner, T.C. Memo. 2011-105, 101 T.C.M. (CCH) 1506, 1521 (2011) See Sanford v. Commissioner, 50 T.C. at 827.

Let’s get a read on these cases to see if there are any crosswinds up ahead before landing:

Sanford case:
“Sanford provided receipts and credibly testified……Therefore, petitioner is entitled to a deduction in that amount for travel expenses, lodging expenses, and registration fees associated with the conferences he attended….”

Lysford case:
“Mr. Lysford testified that all of his airplane flights and his automobile trips to Forest Lake were for business….Other than Mr. Lysford’s very general testimony, petitioners provided no credible evidence that Mr. Lysford sold any mortgages or met with specific clients, mortgage brokers, or title companies in or around Forest Lake…”

Weekend Warrior Trailers case:
“Petitioners introduced into evidence a list of the people who allegedly flew on the airplane and their alleged business relationships, which Mr. Warmoth created from memory….. Such general testimony is insufficient to meet the strict substantiation requirements of section 274(d). We conclude that Weekend Warrior failed to substantiate the business use of the airplane by other sufficient evidence and is not entitled to depreciation deductions with respect to the airplane…..”

Note that only Sanford’s testimony was credited as truthful by the Court. Sanford’s deductions were allowed. I believe Sanford had created a record of facts and history at the time of travel so that years later he could accurately testify to those facts and history. So if you are planning to deduct private business air travel on your tax return this summer, I recommend that prior to any flight make sure you consult your tax professional on how to keep the necessary records all throughout the trip so that your tax return will be bullet proofed in the unlikely event of a crash landing into IRS audit territory. Such contemporaneously created records inserted into a tax return before filing will position your plane safely on course allowing for you all to enjoy a pleasurable and tax deductible business trip. Happy July 4th and safe travel.

Thanks for visiting us at TaxView with Chris Moss CPA. See you next time on TaxView.

Kindest regards
Chris Moss CPA